In the second of a four-part series, Daniel Maguire, the Group Head of Post Trade at London Stock Exchange Group and Chief Executive Officer of LCH Group, discusses the end of Libor, margin pressure and Euro clearing

As the world’s largest clearer of interest rate swaps, LCH has been integral to the industry’s slow migration away from the toxic Libor reference rate to a new breed of so-called risk-free rates.

LCH has worked on all the major switches (sterling, Euro, Yen etc) that have taken place until now but started in late April the conversion of its US dollar-denominated book, by far its largest by notional.

The clearing house plans to phase-out its US dollar Libor contracts over two weekends: April 22-23 and May 20-21.

The first weekend went smoothly as LCH moved across about $1.5 trillion of variable notional swaps and zero coupon swaps. Philip Whitehurst, head of service development for rates at LCH, told Global Investor in late April the second weekend would see a far larger notional moving across, estimating that as much as $43 trillion could convert in May.

Maguire said: “The transition of IBORs to Risk-Free Rates is one of the most existential things that has happened in the industry in a generation. There is the whole Libor transition but the US Dollar one this year is the most significant. We have placed a huge amount of importance on supporting the industry in the two conversion events and we are hopeful they will both take place with no issues.”

The LCH chief said the experience of working on the earlier conversions is valuable as the clearing house prepares for the second, larger migration at the end of May.

“We’ve successfully converted Swiss, Yen, Sterling and Euro indices, as well as a first tranche of USD IBOR linked products, so we have a great amount of expertise and track record in this but really it is a co-ordinated choreography with the dealers, their clients, trade associations, and the other clearing houses.”

But Maguire is not complacent as he looks ahead to May 20.

“The total size of this year’s conversion events is two or three times bigger than the others that we have done in prior years, to give some context around number of trades. It’s a bit of a moving target because trades are expiring and some firms are managing some components of the conversion themselves, but we have seen a shift over the last 12-18 months where the volume of new trades coming in to LCH, be it by DV01 or any other measure, has flipped from 90-10 Libor/SOFR to 10-90 Libor/SOFR.

He added: “By the end of Q2, Libor, at least in LCH, will be gone.”

Margin Discipline

The frenetic trading that Schwimmer mentioned was focused around the near-collapse of Credit Suisse in mid-March this year, leading to the Swiss bank’s ad hoc takeover by its main rival UBS.

At the time, clearing experts speculated that firms had generally dealt better with the volatility and margin pressure than they had in the febrile trading three years earlier as markets reacted to the onset of the COVID epidemic.

Maguire said: “COVID and the recent volatility around SVB and Credit Suisse were very different events. When we look at COVID we are quietly proud that we weren’t seen as pro-cyclical in terms of our margins jumping around. We were able to protect our members while ensuring the safety and stability of the marketplace – we were predictable.”

In 2020, trading firms were quick to blame clearing houses for contributing to volatility by imposing large intraday margin calls, which forced clients to liquidate positions to free up the collateral to meet the calls, thereby increasing the volatility, a phenomenon known as pro-cyclicality.

Maguire continued: “With Credit Suisse, there were some big margin calls given the scale and size of the risk positions, but everyone paid on time, and everyone was well-drilled – which is testament to the huge public and private sector effort since the GFC in 2008.

“While these events may have been different to past ones, people have got much more muscle memory around pre-funding and putting a buffer into the margin account. We’re not in the business of predicting volatility but customers normally sense when it’s coming and proactively prepare for it, which helps the eco-system.”

Maguire concluded: “I am comfortable where we are with our risk methodology, but we continue to scrutinise and back-test every event to test the model – we will never rest on our laurels here. Of course, you must strike the right balance, so the models don’t over-react or under-react and equally they don’t over-hang or under-hang post-events as well.”

Euro Clearing

While clearing is meat-and-drink to a trade rag such as Global Investor, LCH found itself on some unfamiliar front pages after Brexit as European politicians started demanding the repatriation of Euro-denominated swaps clearing.

The European stance has softened over the intervening years, but the European authorities are still uncomfortable with the fact that most Euro-denominated swaps sit in a clearing house based outside of Europe and, therefore, beyond their control.

The latest proposal from the European Commission in December is that firms have an active account with a European Union-based clearing house, though no-one is really sure at this stage what is meant by “active account”.

Maguire (for his sins) has been at the heart of this debate for years now.

“If you look at where we started in 2016 after Brexit, there were a lot of hard statements around a potential ‘location policy’. If you look at where we are now, the narrative has evolved significantly. I think it’s reasonable to say that there isn’t a desire to ‘cut-off’ EU firms from the supply of services from UK CCPs but there is still a desire from the EU to have more capability closer to home.”

He added: “The EMIR proposals are now focused on active accounts, which means that EU firms are likely to be asked or encouraged to have an active account at an EU CCP as well as non-EU CCPs. The European Securities and Markets Authority (ESMA) would be given the task of trying to define that in their rule-making.”

Maguire said he welcomes the more nuanced approach from the European Union but he is mindful of the unintended consequences of requiring firms to clear more of their interest rates swaps in a different clearing house.

“We are supportive of the move away from a location policy, but the real issue is what does this mean for EU firms, such as real-money accounts, pension funds, asset managers and insurance firms?”

He added: “Depending on what prescription comes out of the current negotiations and what mandate will be given to ESMA – and at this stage it is not clear – it could be that EU firms – buy-side and sell-side – have less access than non-EU firms to that global liquidity pool, which would negatively affect them competitively but also affect the way they can manage their risks.”

Clearing houses can calculate and call margin on a client’s net rather than gross position so it is normally cheaper for firms to put all their correlated products under one roof, in this case SwapClear.

Forcing firms to take their Euro swaps out of SwapClear and clear them in Europe could make these products relatively more expensive, thereby putting those companies at a disadvantage.

Maguire said: “It is clear from all the EU based firms that we talk to – whether dealers, pension funds or client clearers – that they want unfettered access to UK CCPs without any kind of limitation. Depending on where the prescription comes out on quantitative or qualitative, that will determine how good or bad this is for EU firms and the nature of financial stability risks in the EU.”

Maguire said LCH’s primary goal is to be able to continue to offer EU-based firms unfettered access to its services, adding: “We are regulated by the Bank of England and ESMA directly, as well as the Commodity Futures Trading Commission (CFTC) and several other supervisors, and we operate a central bank account with the European Central Bank for all our Euros and are directly subject to EU Law (EU EMIR). We are confident that these elements will allow us to continue supporting our customers.”

And the debate about Euro swaps clearing has not affected the demand for SwapClear, Maguire said.

“We continue to see our volumes grow across Euro and other currencies as well. EU firms tend to clear as much in Euro as in other currencies. We’ve seen no discernible change in customer behaviour, and 2022 was a record year in terms of volumes and growth. A lot of people have taken great heart from EMIR 3 and that they will continue to have access to us.”

To be continued on May 17